Bond Market Blues: Fed Snaps up $9 Billion in Government Bonds

There's certainly been no shortage of news to analyze lately. One of the biggest items being the Federal Reserve's announcement that the agency will restart its buying of U.S. Treasury securities.

We haven't seen this game for a while. In the wake of the financial crisis, the Fed stepped into the Treasuries market in an attempt to keep interest rates low. Between April and October of 2009, the Fed bought $300 billion worth of U.S. government bonds, notes and bills.

Then they stopped. At the time the word was things were now secure in the bond markets. Private buyers were stepping in, eliminating the need for government intervention.

We went nearly 10 months without any significant Fed bond monkeying. (In the meantime, the agency forayed into the mortgage-backed securities market, buying $1.1 trillion in MBS.)

But it appears the good times are back off again in the bond market. Over the last three weeks, the Fed has made good on its promise and snapped up $9 billion in new government bond purchases. As the chart below shows, the trend is once again marching upward.

The interesting question is: why?

A year ago when the Fed intervened in bonds, yields were running high. The 2-year security stood near 1% yield. The 10-year was 3.8%.

Today, the 2-year bond is half that level. The 10-year yield is 30% lower.

Given that credit flows are still stunted in the U.S., the Fed probably wouldn't mind seeing yields lower still. But this isn't the main reason the agency is taking the drastic step of direct bond market tinkering.

A more likely explanation is a covert bailout of the financial community.

Over the last two years, a lot of investment money has flowed into U.S. government bonds. So far this fiscal year, the American public has purchased $1.15 trillion worth of Treasuries. In Fiscal 2009, public purchases totaled a whopping $1.75 trillion.

Much of this was safe-haven buying, as investors looked to wait out the economic storm that touched off late in 2008. With things today looking (somewhat) better on the world economic stage, some Treasuries holders are now selling and moving back into stocks, commodities and other higher-return investments.

An increase in such selling would almost certainly send bond prices lower (and therefore yields higher). Something the Fed doesn't want to see. To compensate, they are stepping in with increased buying to absorb any paper hitting the market.

This is a new step in America's money "shell game". Initially, the government leant money directly to troubled financial institutions. Those institutions in turn leant the money back to the government, by buying Treasuries. Now the government (via the Fed) is encouraging money to flow back again to the private sector by giving them fresh cash for their bonds.

Here's the big takeaway. Normally, all these flows of funds should move interest rates up and down. Significantly. But the government is orchestrating things, using the national balance sheet to mute any interest rate signals. The reason things look relatively orderly in the bond markets even as we go through massive cycling of dollars.

An important note for anyone expecting the bond market to provide a signal of impending financial troubles. This "early warning system" may be broken.

By. Dave Forest of Notela Resources